What is a peer-to-peer loan?
To understand peer-to-peer loans, it helps to start with how this loan differs from a traditional loan. There are two types of peer-to-peer loans: personal and small business. Unlike a traditional loan, a peer-to-peer loan is funded by investors or a group of investors. Also referred to as "P2P" or "crowdlending," these loans are available only through online marketplaces. Once someone applies for a loan, the marketplace (or lender) matches borrowers with investors willing to make the loan. It's the marketplace that reviews loan applications, underwrites the loan, and assigns it to a risk category.
Risk categories
The assigned risk category is based on factors like credit score, debt ratio, and employment history. Here's how it works: An applicant with a low credit score is considered a high-risk borrower. Any P2P lender (or lenders) that agree to lend that person money knows they're taking a risk. Therefore, the interest rate on the loan is set higher. That higher interest rate is why some lenders choose that borrower's profile over others.
On the other hand, a person with a high credit score (and other positive credit factors, like a low debt ratio), is categorized as low-risk. While lenders won't earn as much interest funding this loan, they're also taking less risk.
For an investor who wants to "mix up" their lending portfolio, it makes sense to fund some high-risk and some low-risk loans, but that's up to the investor.
Secured and unsecured loans
A secured loan is secured by collateral. Say a small business wants to borrow $100,000. To help minimize the risk of loaning that much money, a P2P lending platform may require the business to put up collateral. It could be anything of value, from a small airplane to a vintage car, or business equipment. If the borrower fails to make payments as agreed, the lender has the right to take possession of the collateral, sell it, and recoup the loss.
An unsecured loan requires no collateral but may carry a higher interest rate. Still, if you've decided that it's better to finance a project rather than pay cash, it may be worth it to pay a bit more interest for a loan that does not require collateral.
How to apply for a peer-to-peer loan
The best peer-to-peer lenders make it easy to apply through their websites. Here is the information and documentation you'll need to supply:
- Name
- Address
- Date of birth
- Proof of employment
- Proof of income
- Social Security number
- Personal information, like whether you currently rent or own your home and how much debt you carry
- If you're applying with a co-signer, you'll need to provide that person's information too.
Apply from a position of strength
As you've likely noticed, the lowest rates and best loan options go to those with the highest credit scores and best overall financial picture. One of the worst mistakes a borrower can make is to believe they don't have control over their credit score or that they must accept whatever interest rate they're offered. That is simply untrue. If you're taking out a loan to renovate your home, go on vacation, or for any other reason that can wait, decide whether you can postpone the loan until you've had time to increase your credit score.
Here are five ways to quickly boost your score.
1. Check your credit report
Once a year, you are eligible for a free credit report from each of the "big three" credit reporting agencies. You can order your free reports from Experian, TransUnion, and Equifax by submitting one simple form at annualcreditreport.com. Once you have your reports in hand, go over each with a fine-tooth comb.
You're looking for any mistakes that may be contained in those reports. For example, a report may indicate you still owe money on a debt you've paid off or include a debt that does not belong to you. If you find a mistake, dispute it with the credit reporting agency in question. The agency has 45 days to find evidence that its report is correct or to remove the remark. Even the smallest mistake in your credit history can drag your score down, so make sure there aren't any.
2. Stay current with bills
Each late or missed payment lowers your credit score. In addition to paying all current bills on time, focus on getting caught up on anything that may be overdue.
3. Don't close paid-off accounts
Closing unused credit card accounts may seem like a good idea but it will actually harm your credit score. By keeping them open, you're indicating you have access to credit but use it wisely.
4. Apply for credit only when you need it
Your credit report indicates each time you apply for credit, and creditors worry about anyone who appears to be opening several accounts during a short period of time. Only apply for credit you actually need.
5. Get help from the outside
Things like rent paid to a landlord and utility payments are not typically reported to the credit bureaus. Into that void has stepped companies that, for a fee, will make sure rent and utility payments get reported to all of the big three credit reporting agencies. Those positive reports can quickly build your credit score. However, there is a fee involved. For example, ExtraCredit.com charges $24.99 for the service. If you're looking to build your credit score fast, though, it is worth looking into.
Most peer-to-peer lenders conduct a soft credit check, which means it won't impact your credit score. It's not until you commit to one lender that it runs a hard credit check that will ding your score a bit. Don't worry, though. A few on-time payments will send your score back up.
Apply with at least three lenders (within a two-week time frame so all personal loan inquiries appear as one on your credit report). Once you have approvals, compare them side by side to determine which works best for you. The best way to pay a loan off fast is to go with the lender that has the lowest interest rate and loan fees.
When a P2P loan makes sense
If one of the following applies to you, include peer-to-peer lenders as you're shopping for a personal loan. Even if you end up going with a traditional lender, you'll know that you investigated all options.
- You have a low credit score. If you find you don't qualify for a traditional personal loan due to having a bad credit score, you may find a peer-to-peer lender more forgiving.
- You have a high credit score. When comparing the best personal loans, include a few peer-to-peer lenders. It may be a peer-to-peer lender that offers the lowest rate and best loan terms.
- You own a small business. If you have a business plan that makes sense and you're confident you can repay the loan, a business loan can help
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